Wonneberger

Taking artwork as collateral presents the lender with a number of issues not generally present with other types of assets. Adding a further twist, these issues may have a different impact depending on whether the collateral is provided by a gallery or an individual collector. This article describes three of these issues - consignment, state artist protection laws and possible secret liens; and discusses how secured lenders can address them.

Consignment

Issues regarding consignment arise more frequently with art than for most other types of collateral. Risks and risk management strategies differ based on whether the collateral is provided by a gallery or a collector.

Generally speaking, under the Uniform Commercial Code (“UCC”), if the owner of a work of art delivers it to a gallery for the gallery to sell, the arrangement is a consignment,1 and the gallery is deemed to have the same rights to transfer the piece as the owner.2 If these UCC consignment rules apply, the gallery can sell the piece or grant a security interest to its lender, defeating the rights of the actual owner.

Two of the factors that can take the arrangement outside the definition of a consignment are particularly relevant in this context.

The arrangement would not be classified as a consignment if the gallery is “generally known by its creditors to be substantially engaged in selling the goods of others.”3 Although this may seem like a simple determination, it actually requires a detailed factual analysis. For the “substantially engaged” prong, a lender can assume that if more than 20% of the gallery’s inventory is on consignment, the gallery may be “substantially engaged in selling the goods of others.”4 The “generally known by its creditors” part of the test is more complicated. A party must prove that a majority (in number, not dollar amount) of the gallery’s creditors know that it is substantially engaged in selling the goods of others.5

The arrangement also would not be a consignment under the UCC if the artwork is classified as “consumer goods” immediately before delivery to the gallery.6 Consumer goods are “goods that are used or bought for use primarily for personal, family or household purposes.”7 If the artwork is owned by an individual who bought the artwork for his home, it would likely be classified as consumer goods (especially if the owner does not frequently buy and sell artwork), and the UCC consignment rules would not apply.
Unfortunately, there can be no certainty regarding whether the UCC consignment rules apply without a judicial determination. When collateral is provided by a gallery, lenders should assume, or at least consider, an unfavorable outcome when structuring and administering a transaction.

The UCC consignment rules, if applicable, are very helpful to lenders when the collateral is provided by a gallery. They expand the lender’s collateral to include consigned artwork, even though it is not owned by the gallery. To maximize the lender’s position, the security interest itself should be crafted to encompass all artwork inventory.

However, given the uncertainties described above, when structuring and administering the loan, the lender must take steps to protect itself against the possibility that the UCC consignment rules do not apply, its security interest does not extend to the consigned art, and the consigned art is not considered an asset of the gallery available to satisfy its debts. Steps that a lender should consider include the following:

Including only artwork owned by the gallery in the calculation of any borrowing base or collateral formula, or in any loan-to-value or similar covenants, or including consigned artwork on a reduced or modified basis.\

Requiring the borrower to provide additional information about consigned inventory including the name of the consignor and the length and terms of the consignment.

Requiring the borrower to maintain fine art/casualty insurance in an amount sufficient to cover all inventory, including consigned art.

Adjusting financial covenants, if necessary, to take into account consigned inventory and consignment arrangements.

The lender must also consider the possibility that a gallery will consign its inventory to another gallery.
If artwork already subject to a security interest is delivered to a gallery for sale and the UCC consignment rules apply, the lender could lose its collateral. The UCC provides a method for the consigning owner to protect its interest but, in many cases, the owner does not avail itself of that protection.

Under the UCC, the interest of a consigner is treated as a purchase money security interest in the consigned artwork.8 The consigner’s interest and priority can be protected by following two simple steps9:

First, the consigner must properly file a UCC-1 against the consignee gallery before the artwork is delivered to the gallery.

Second, if there is a prior perfected security interest in the gallery’s inventory, the consigner must send authenticated written notice to each such secured party. The notice must describe the artwork being consigned and state that the owner has or expects to acquire a purchase money security interest in inventory of the gallery. That notice must be received by the prior secured party before the artwork is delivered to the gallery.

A lender should assume that if its artwork collateral is delivered to a gallery for sale, the UCC consignment rules would apply, and the lender’s rights could be defeated. In order to protect against this situation, the loan documents must require that before any collateral artwork is delivered to any party for sale, the owner must comply with the protective steps described above and provide the lender with satisfactory proof of compliance, including a recent UCC search for the gallery to which the artwork is delivered. Additional steps to consider include the following:

Requiring prior written notice, and/or lender’s prior written consent, before the artwork collateral can be delivered to any party for sale or its location changed.

Periodic verification of collateral location and the right to conduct inspections.

If there is a consignment, a requirement that the lender be provided with a copy of all documentation and an agreement that the documentation will not be modified without the lender’s prior written consent.

If there is a consignment, the lender may wish to seek an agreement from the consignee gallery to protect the lender’s interest.

Artist Protection Statutes
A number of states have statutes providing special protection for the rights of artists (and sometimes others) when dealing with art dealers. Unlike the UCC, which is uniform (or mostly so) throughout the country, these statutes differ and are not present in all 50 states. Below is a general discussion of the statutes from two states, New York and California, to provide examples of issues these statutes raise.

The New York10 and California11 statutes provide examples of the types of provisions often found in these laws. Substantively they are very similar, but differ in the details. Some of the important provisions include:

Both statutes deal with works of art, but the definition, and thus the scope of what is covered, differs somewhat.

Both statutes protect artists and certain successors, although again, the scope differs slightly.

If a covered party delivers art to an art dealer, the dealer holds the art and its proceeds as trust property.

The artwork remains trust property even if the dealer purchases it, until the full purchase price is paid. Under the California statute, even if the art was initially delivered to the dealer as an outright sale (rather than for sale to others), the art and the artist are still protected until the purchase price has been paid in full.

While the consignment arrangement is in place, the art is not subject to claims of the dealer’s creditors.

Both statutes expressly supersede the UCC.

Where the application and applicability of the UCC consignment rules involve some uncertainty, these statutes do not. They are clear and explicit that the security interest of a lender in the inventory of a dealer/gallery does not extend to artwork held by the dealer that falls within the statute. This protection may even extend to artwork inventory actually owned by the gallery until the purchase price has been paid in full. This last point is a major departure from other types of inventory as, generally, a security interest attaches to inventory once it is purchased by the borrower, regardless of whether it has been paid for.

Initially, the existence of this type of statute should put a lender to a gallery on a line of inquiry:
Does the applicable jurisdiction have this type of statute?
What types of items fall within the statute?
What types of transactions fall within the statute?
Does the borrower’s inventory include any items and transactions covered by the statute?

Since the lender knows that items covered by the statute are not part of its collateral, this must be taken into account when analyzing and structuring the loan transaction. A lender can take steps similar to the ones addressing the consignment issue such as specifically addressing protected artwork in borrowing base or other collateral formulas, loan-to value or similar covenants, and financial covenants; requiring separate identification in inventory reports; requiring additional information for inventory covered by the statute; and requiring sufficient insurance to cover all inventory, including items subject to the statute.

Consumer Goods Priority Issue
Assuring that the lender is obtaining a first priority lien is usually a simple process. A UCC search is obtained and any existing or prior liens are addressed. Unfortunately, under certain circumstances, there may be a prior perfected security interest that will not show up in a search.

Under the UCC, a purchase money security interest in consumer goods is automatically perfected without the need to file a UCC Financing Statement. If the owner of consumer goods financed all or part of their purchase (either with the seller or by borrowing from a third party) and granted a security interest in the acquired goods to secure the financing, that lien would take priority over a security interest granted to a new lender. The new lender may have no idea that the security interest exists.
Although there may be some uncertainty about whether artwork owned by an individual constitutes consumer goods under the UCC, when addressing this issue, a lender should usually assume that artwork owned by an individual borrower will be classified as consumer goods. Unfortunately, there is no perfect way to make sure this type of secret lien does not exist. The issue can only be addressed by verifying through other sources that there is no existing purchase money security interest. At one end of the spectrum, a lender can obtain representations and warranties from the borrower. At the other end, the lender can conduct a full review of all documentation regarding the borrower’s acquisition of the artwork, including proof of payment in full. The scope of the inquiry may depend on such things as the value of the artwork, whether it constitutes a substantial portion of the total collateral package, and the extent to which the lender is relying on the collateral. If the investigation reveals any existing security interests, they can then be addressed.

Conclusion
A lender taking artwork as collateral will have to contend with a number of uncommon, and sometimes unique, issues. These include the UCC consignment rules and the uncertainty as to when they apply, the possibility of a collector and its lender losing their interest in artwork consigned for sale, the restrictions and limitations imposed by state-specific artist protection statutes, and possible secret liens against artwork owned by an individual. Proper investigation and documentation can help mitigate some of these issues and protect against some of the common pitfalls that arise with this type of collateral.

Robert M. Wonneberger is a shareholder in the New Haven, Connecticut office of national law firm LeClairRyan. His practice includes commercial, asset based, and mortgage finance; lending to high net worth individuals; debt restructures and workouts; problem loan resolution and commercial law.